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Moats aren't forever

Most investors seem attracted to growing companies with large competitive advantages (a moat). Who wouldn't want to own Apple as it went on to dominate the world. Companies with moats are the types of stocks people talk about at parties when they say things like "I purchased Proctor and Gamble in 1988 and it paid for my retirement."

Growth investing will always be popular with a large segment of the market. I know many co-workers have invested in "growth" funds because they want their money to grow, a fund with value in the name just sounds cheap, like a value meal at a fast food joint. It doesn't help the image that many value investors are actually cheap themselves, some even fall beyond the cheap realm into the miser category. Investors have a choice between a growth fund run by a slick looking guy wearing fancy clothes and driving a nice car and some value fund manager who's sport coat has elbow pads and drives a gremlin.

Many readers know that I don't seek out companies with moats or competitive advantages as the market sees them, but I pick through the market's dustbin. I don't think I've ever articulated why I don't seek out moat-ish companies, so I want to use this post to lay out my thoughts.

This idea came to me recently as I was reading an article about the recent Carnival Cruise Lines incident. For readers who were unaware a Carnival ship had a fire which left it disabled in the water for a week. Passengers were trapped without food, water or toilets. The biggest story seems to be that passengers had to sleep on the decks and that raw sewage was running through the halls. As I was reading the article I started to think about a series of posts Geoff Gannon and Quan Hoang wrote here about Carnival and the company's moat.

I wondered how badly Carnival's reputation would be harmed from the incident, some customers might shrug it off and say it wasn't the cruise line's fault, but for many others the name would be connected with a terrible experience. No matter how many free vouchers Carnival gives to customers the brand damage has been done.

I thought about this in a broader context, the difference between investing in a cheap stock, and investing in a company with a moat. A company with a moat needs to always be innovating and leading the pack to ensure their moat is safe. One or two missteps could destroy their advantage entirely. Maybe Carnival's advantage is their economy of scale, but scale doesn't matter if customers don't book cruises. A company with a moat cannot sit back and rest on their success, the second they do they lose the lead. Value investors are familiar with a number of companies that lost their moat such as Blackberry, Radio Shack, Best Buy and others.

On the other hand a cheap deep value stock is just the opposite. The market has priced these stocks as if they are worse then dead. I sometimes think of deep value investing like this, it's as if everyone predicts a city will be utterly destroyed by a nuclear bomb but instead most of the city just catches on fire. When expecting a nuclear bomb a city-wide fire is a relief, complete destruction didn't happen. Deep value investors need to be ready for bad news, it will happen, it will happen often and frequently. But sometimes the bad news isn't as bad as the market expects causing the stock to rise. The corporate corpse is found to have a faint pulse and investors rejoice, certain death was avoided and the company is repriced.

There's a completely different mindset required for investing in value companies verses moat companies. To invest in a value situation all one needs to be sure of is that death isn't certain. If a company isn't terminal, and has value then it could be worth an investment. There is no glamour in buying these stocks. No one recognizes the names in my portfolio, but that doesn't bother me, returns don't come from popularity.

I'm convinced buying companies with a competitive advantage and concentrating a portfolio is the path to riches. There isn't anyone on the Forbes 500 list who constantly churned a portfolio of net-nets, they all founded companies with competitive advantages and put their entire net worth, and often their entire life into the company, the epitome of concentrating an investment. If one wants to be rich I think they need to be an entrepreneur, they need to find an unserved niche and serve it and pour everything they have into that company.

If one can't start a company themselves the second best thing they could do is to invest in a company that has those characteristics. Many more people made money investing in Starbucks or Microsoft when they were startups than investing in mature companies with leading competitive positions. Buying into a small company with a defensible niche is probably the second quickest path to riches.

The problem is most investors really don't know what they're looking for when they're looking for a moat. I was on a flight recently and started talking to my seat-mate. Maybe this sounds weird, but I can't help myself from talking to people. If I'm standing next to you for more than a minute we'll be in a conversation. It turns out he owns a large trucking company familiar to almost any American who has ever driven on a US highway. We talked about the trucking business and some of the challenges he faces along with the Ravens, skiing, and kids. He made a comment that was interesting when he said "just like all businesses you need to figure out what you can do a little bit different that causes customers to use you." His business specializes in certain types of loads, and runs their network in a unique way.

What struck me about his comment was that he's correct, and that our view as investors isn't the same as the people who run the businesses we invest in. In an finance textbook trucking would be considered a commodity business. One truck is equivalent to any other truck, they can haul loads the same, and it's doubtful anyone would claim a trucking company could have a competitive advantage. The thing is in the real world every business that's in existence has a competitive advantage, if they didn't they would be gone. Each company has something that's a little different that causes customers to do business with them.

Investors without in depth industry experience, or a deep network of contacts can sometimes mistake a normal competitive advantage with a durable lasting one. They are deluded into thinking a given company has a moat, when in reality every company has some advantage. An investor who can correctly identify moats at small and growing companies will do well for themselves over the long run.

To me a deep value investor is like a doctor who can walk into a room and identify quickly that the patient is going to live. A moat investor is a doctor who can walk into a room and tell that the patient is the next Frank Sinatra.

16 comments:

I guess it depends a bit on what your view of a competitive advantage/moat is. Creating a successful business requires filling a gap in the market, and offering something new/better/cheaper. People must have some reason to do business with you!

But is it a competitive advantage that allows the company to earn an above average return on equity? And is it an advantage that the company can maintain if competitors are attracted to the higher than average returns? Those are the questions that really matter for the investors looking for the next Microsoft or Starbucks.

I'm by the way thinking that a trucking business could certainly have a moat, but obviously hard to tell without knowing anything about the industry or the company in question.

A new business doesn't need to offer anything new/better/cheaper, they can offer the exact same thing, but be slightly different. Or offer the exact same thing and market their product better to get customers. Advertising and marketing are underrated by investors, a company with an inferior product and price with superior marketing can outsell a better product.

An excellent post Nate! A lot of value investors can't tell the difference between a normal competitive advantage and a durable one but you nailed it! Especially with your last two sentences:

"To me a deep value investor is like a doctor who can walk into a room and identify quickly that the patient is going to live. A moat investor is a doctor who can walk into a room and tell that the patient is the next Frank Sinatra."

I've been reading your blog for a few weeks and am really impressed by your insights about your thoughts about value investing.

Recently I stumbled upon a quote from Warren Buffett which I forgot for a while and this time it wouldn't go out of my head: On several occasions Buffett said that he could make 50% per year if he only had a small fund and less money to invest. ($1 Mio)

In the same time I reread a lot about Buffets / Mungers four filters investment philosophy:1. Moat / Competitive Advantage2. Management3. Margin of Safety4. Circle of competence

Now I am wondering if Buffett would invest with his 4 filters strategy if he wanted to achieve that 50%. I am absolutely convinced that the four filters is the ultimate investment strategy. Otherwise I don't know if this is also true if you have less then 1Mio$ to invest.

You certainly know the advantages of small / micro cap investing:- large investors can invest in these stocks- they aren't on the radar for most investors- nobody talks about them -> Like you said: No one knows the name of the stocks in your portfolio. This makes less fun to own them because you can't talk with friends about them.

If you would want to invest in these small, deep value stocks with the 4 filters strategy in mind, you would probably fail 90% of the time because they have no moat (durable moat).

I tried to research more about the "50%" quote of Warren Buffet and I am getting more convinced that he would achieve that with looking for deep value stocks. I am not competely sure but I think he said in this context, that you have to turn around a lot of stones, but eventually you will find them.

To cut a long story short... I think this is a super interesting topic and would love to hear you thoughts about that.

Essentially it's the question: How do you think would Warren Buffett invest if he only had 1 Mio$ ?

Yes, very interesting question. I'd refer you to this video of Buffett answering the exact question: http://www.neatvalue.com/2012/05/one-of-best-bargains-i-stumbled-upon-in.html

He says if he had small amounts of money he'd be looking at the classic Graham stocks, where buying enough cheaply you could almost not go wrong. He'd also go for a great company at a low price, but my feeling is those don't come around as often.

Btw, I love this quote -- I'm printing it out and taping it on my wall (oddly, it's not how I invest at all today):

"I'm convinced buying companies with a competitive advantage and concentrating a portfolio is the path to riches. There isn't anyone on the Forbes 500 list who constantly churned a portfolio of net-nets, they all founded companies with competitive advantages and put their entire net worth, and often their entire life into the company, the epitome of concentrating an investment. If one wants to be rich I think they need to be an entrepreneur, they need to find an unserved niche and serve it and pour everything they have into that company."

I don't mean to reply for Nate, but I believe Buffet was talking about investing in truly small, NANO cap companies...usually companies with market caps of UNDER $10 million USD. Buffet was also talking about small arbitrage situations, ie. investing in companies cashing out small shareholders. For example company is doing a reverse split of 500 for 1. You own 400 shares, you getting bought out in 2 months and will receive $150 profit on the transaction. (You might have 2 accounts that you do this in, Cash account, IRA account) and you make $300 on a $2500 investment in 2 months).

He was also referencing going into foreign markets (Korea if remember, he bought a flour milling company at like 4X earnings and .5/BV, while paying a 6% dividend and very little debt).

There have been numerous bankruptcy situations in 2012 where you could have made 10x, 20X or even 75X on your money if you were paying attention to the bankruptcy reorg plans.

A few times a year, I will see NANO cap companies sometimes get sold off and trade at a 1X or 2X P/E ratio.

You have to put in a TON of time & effort to become familiar with these companies and situations, but they are out there. You would probably also have to work at it at least 20 hrs. a week, if not more.

It certainly can be done....I've done it myself a few times. Just need to do it like 1 time a month!

I think Buffet is right, you can make 50% returns if you are willing to dig & do the work...

Thanks for the response, I agree to an extent. I posted a link to Buffett answering the question above, he said the Graham cigar butts is what he'd do with $10m or less.

You're right that it's a multi-pronged approach, buying the cheap stuff, like Korea (Japan and Europe now), along with the nano-stuff, and special situations. I think the special situations are getting a lot of play recently. The PPG offer was one where a significant amount of money could be moved. An investor could tender $13k on the offer and make 11%, the actual return came out closer to 25%, and if anyone held they're at 35% right now. So a $4550 gain per account, multiply that by a few brokerages and that's some serious money. But for someone managing $15m it's not worth their time.

I'm involved in a special situation that has a similar potential. The stock is going private at $7 per share, shares trade at $3.50-$3.95. The problem is shares aren't out there to buy, I've tried, I have outstanding bids but not much as filled. The price isn't the market saying they doubt the deal, it's that there is no liquidity. The deal is guaranteed, a US court ordered it, it's just shares don't trade. And for the hordes that are searching for this stock now it doesn't file with the SEC and news is non-existant. All of the information I've received in the mail from the company attorney.

Someone gave me some great advice, in the nano-world liquidity will suddenly appear and a stock will dump for no reason. In most cases it's someone who inherited the shares are are unloading for no reason, this is the time to buy. I have a holding it sold off 30% recently, it's selling for 43% of net cash, I'm buying..

I dont agree with the assumption that to earn money you have to have moat. You can make money without moat. Quantitatively you can check whether the company has moat is by looking at ROIC, ROE. Then you can dig further to figure what is repsonsible for high ROIC which makes your moat. I can give you an example of corner stores. Most of the corner stores make money without having any moat. Most of the corner stores sell same stuff and most of the them at same price and expense. choice of store depends on your convinence. BUt question becomes what is the ROE or ROIC. Probably if i have to guess is low but still they continue to operate, question is why ? As long as they make money rather lose they can keep doors open and take care of their daily living. They don't care what is their ROE or ROIC. It only becomes a question when you think about opportunity return on investement. Most of the people dont think in that respect. Otherwise everyone will close the shops and invest in high return companies. Even if they know about it, they will invest and be idle at home which goes against human nature. Yes people always want to do something different which will enhance their earnings but same is true with other person hence will cancel first person's advantage. However some bussiness are inherently high return from start (network advantage google, ADP, high intellectual capacity involvement which is rare to find MSFT, apple) and in some cases very smart ppl ( small percentage in world) at the top make bussiness high return. Wal-mart. They make decisions or intiate processes which takes times for other person to decipher and by the time he figures it out, he had lost time and market. black berry.

Good comment, and good examples. In some ways those stores do have an advantage, usually location. A corner store on a deserted street won't have any business, one on a busy street will. People go to corner stores due to location, not prices (which are usually high anyways).

You're accurate that almost no one looks at ROIC or ROE. It's good, because a lot of poor companies that are necessary would be gone!

Often times just "being there" is a competitive advantage. A competitor won't open a gas station on that side of the road because a gas station is already there. A grocery chain can't open an inner city grocery store because the required floor space and parking has already been occupied by another grocery store.

Rational entrepreneurs seek out gaps and niches in the market which means that businesses which are already operating are left undisturbed for no other reason than that they were already there. It's only when entrepreneurs behave irrationally that they enter a market and cause industry wide returns to fall below the cost of capital. From a business school perspective this behavior is random because it does not follow rational principles. From observation it tends to happen in industries that people think are exciting or that people get into for no other reason than that everybody else is doing it.

A business being in a boring, obscure and uneventful industry can therefore be a lasting source of excess returns on capital.

I am not sure location or for that matter any temporary advantage constitutes a moat. Every bussiness has some temp advantage till some big boy comes and destroys it. It is like being a smart guy in a class and lot of girls like him, though has not happened with me, and he is enjoying it. His IQ is not that great but he studies very hard to keep his position. Now a new guy comes who has higher IQ and also works hard. Due to him having high IQ he becomes smartest guy and now he is getting attention of all the girls. First guys advanatge was temp as long as there was not another guy smarter than him, once that happened all his advantage vaporised. Lets us talk about retail shops, in my neighbourhood, corner shops were there for decades making decent living but once big boy wal-mart came everything changed. within few yrs all those shops were gone. Now take Google, what an advantage , MSFT spend billions of dollars and reports say it is better but google is still the king, you can say google had already been there . Yahoo was present prior to google but overtook them.

I don't agree with the fact that you say every business in existence has a competitive advantage. Firms without a differentiating product will operate in a perfectly competitive market absent of any profit. There are many small firms that just make enough to cover the salaries of the owners/operators without turning a profit, or turn a profit that just covers the cost of capital of the firm. Most firms operate would under this circumstance. Few firms have a true competitive advantage that lets them earn in excess of their cost of capital for extended periods of time.

I dont know if I agree about the power of marketing. Yes all things being equal -ie equal size companies then the one with the better marketing may make more sales and more profits. But marketing and brand building come at a cost and it is in many cases a cost that needs to be continued every year.....the brand will be eroded without the marketing. SO if you are a large competitor and have a large footprint wear your marketing costs can be spread over a wide area then this may prove very efficient. But think of a small start up that tries to take on the incumbent with marketing alone and the same product - they will blow their brains out. The costs of marketing the product will ensure no return on equity or worse